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Roller-Coaster Stocks

Risk doesn't necessarily equal reward, but it's not a bad place to start.

The thousands of stocks trading on the public markets rarely move in sync. The historical market average, after all, is just that: an average of stocks that have gone up, stocks that have gone down, and stocks that have gone nowhere. Index funds are incredibly popular low-cost vehicles for tracking the market average, but if you have the time and temperament, you have the potential to crush the average by investing in individual stocks.

But just how far ahead of the market average can you get? And to beat the average, must you assume huge risk? Risk is measured by a finance term called beta. The beta of a stock tells you how volatile the stock price has been compared with the market overall -- basically, the height of the roller coaster's peaks and the depth of its dips. The market as a whole is assumed to have a beta of 1. Stocks with high betas are highly volatile, which increases risk. But risks are where the rewards are, right?

Sometimes, but not alwaysTake a look at the table below, which presents some of the most volatile stocks of the past year along with their corresponding returns in stock price.

Company

One-Year Beta

One-Year Return

DayStarTechnologies

4.4

429.4%

Homestore

3.6

164.3%

Salesforce.com(NYSE:CRM)

3.4

175.5%

HurcoCompanies(NASDAQ:HURC)

3.2

129.1%

As you can see, high-risk stocks can end up as huge winners. If you'd invested $1,000 in Salesforce.com's growth story over the past year, you would have almost tripled your money! So risk can be a good thing. As companies build their businesses, take on debt, or go through spurts of unprofitability, the inevitable volatility in their stock prices tends to scare many investors away and provide an opportunity for the bolder investor.

But risk is no guarantee of reward. Take a look at the following stocks. These were the high-risk losers over the same time period.

Company

One-Year Beta

One-Year Return

GlycoGenesys

4.1

(73.2%)

BriteSmile

3.9

(68.8%)

InnovoGroup

3.8

(72.7%)

MediaBay

3.5

(82.2%)

iMergent

3.3

(67.3%)

And there, in a nutshell, is the downside of risk. A focus solely on beta could cause a crushing loss of capital.

What if we play it safe?But that doesn't mean you should automatically fear volatility, because the alternative isn't necessarily any better for your portfolio. If you had gone the other route and invested in some of the market's most stable stocks, you might have lost money as well.

Company

One-Year Beta

One-Year Return

Gap(NYSE:GPS)

1.0

(17.8%)

Lucent Technologies(NYSE:LU)

1.0

(24.6%)

VerizonCommunications(NYSE:VZ)

1.0

(14.3%)

Citizens Communications(NYSE:CZN)

1.0

(8.0%)

Disney(NYSE:DIS)

1.0

(7.9%)

All data provided by Capital IQ, a division of Standard and Poor's.

Obviously, picking stocks based solely on volatility isn't the answer. Big risk can equal big loss, and there's no guarantee from the market's least volatile stocks, either. Many of the latter companies have been around too long to be able to come up with innovative ideas and break out of their mold.

Take Disney, for example. Disney's been around for years, and shares have generally been as volatile as the Winnie the Pooh ride is for toddlers. But although its stock has moved relatively in sync with the market, an investor would have lost money in Disney over the past year. That's because with new companies like Pixar and DreamWorks Animation taking market share, even its animation department has struggled to maintain its audience. Its most recent offering, Chicken Little, has grossed a disappointing $130 million thus far. Disney's compound annual growth rate for sales has also been decreasing, currently at an unimpressive 5% a year over the past five years. (Find out how Disney's trying to remedy this by making a deal with Pixar.) So safe isn't always the best place for your money, either.

Foolish bottom lineWhat's an investor to do? First, figure out your optimal level of risk. Are you a Scooby-Doo Carousel type, or are you up for a ride on Space Mountain? Next, figure out the risk level of some stocks that have caught your eye. If you're not sure where to look, David Gardner's Motley Fool Rule Breakers newsletter service recommends two high-growth companies every issue, helping you catch them early in their growth stage, before everyone else has already squeezed value out of its stock. Companies like Intuitive Surgical, which has a beta of 2.1 but has also had returns of almost 200% since David recommended it. With a 30-day free trial, you get access to 31 stock picks, which over the past 14 months have outperformed the market by nearly 20 percentage points. And each one includes extensive research and analysis, so you don't have to worry that you're investing in risk without the reward. Click here to learn more.

Maybe you like the thrill of a wild ride. But every ride is a lot more enjoyable when there's a reward waiting at the end.

Shruti Basavaraj is a Fool research analyst.She loves roller coasters but refuses to get on the swinging pirate ship ride. Shruti owns shares in Pixar. Pixar, DreamWorks, and Gap are Motley Fool Stock Advisor recommendations. Gap is also an Inside Value recommendation. Citizens Communications is an Income Investor pick. The Fool has a disclosure policy.